Oil hit by weaker Euro, slower demand growth

Commodity Online Sovereign debt crisis in Europe, a much weaker-than-expected Euro and slightly higher-than-expected non-OPEC supply has forced Bank of America-Merrill Lynch (BofAML) to revises its WTI and Brent crude oil forecasts for second half of 2010 from $92/barrel to $78 per barrel. Yet despite the much reduced likelihood of a robust upswing in global economic activity, BofAML remain cautiously optimistic that the breadth of the recovery outside Southern Europe will prevent a double-dip scenario. Hence it has maintained its 2011 WTI and Brent crude oil price forecast at $85 per barrel.

In view of the slower global economic growth ahead, BofAML has lowered its 2010 world oil demand growth forecast to 1.5 mn b/d from 2.0 mn barrels earlier. It has now predicted 20,000 b/d of growth in OECD regions in 2010 and 50,000 b/d of growth in 2011.The demand expansion in North America and OECD Asia will be offset by contraction in European oil consumption.

Emerging markets will account for greater share of increase in consumption led by China.

On the supply side, non-OPEC countries will expand their supply by 583,000 b/d annualy to 52.1 mn b/d compare to BofAMLs previous estimate of one percent growth.In 2011, non-OPEC supply will rise to 52.4 mn b/d, which is up by 357,000 tonnes or 0.7%. Major additions will come from projects starting in Brazil, China, and the US and continued ramp up of projects that started last year

A riskier macro environment and a weak supply/demand balance around Cushing, the NYMEX delivery point, triggered a sharp WTI crude oil sell off during the past week.

European banks are becoming more reluctant to lend Since European banks are large holders of sovereign debt, a sequence of defaults or even just downgrades in the region could precipitate a large correction in bank assets and in turn increase collateral demands. On the liability side, bank funding costs have risen sharply following the rise in sovereign credit spreads Surely, the policy measures announced two weeks ago should ease funding pressures in the near term for European banks, but the recent moves in LIBOR-OIS spreads are showing signs of some short-term funding strains. These moves are not good news for the real economy, as the global economic recovery is partly predicated on an inventory restocking cycle and increased fixed asset investment, two of the most volatile components of GDP. With funding drying up, many companies will likely postpone investment decisions, reducing demand in the short-run, BofAML analysis said.

European sovereign debt crisis encouraging flight to safety Implied volatilities in cyclical asset classes such as equities and commodities have also spiked in the last month. Investor flows are largely reflecting a flight to safety, and leverage is being reduced across various financial markets. The combination of higher sovereign risk, a falling Euro and the financial regulation bill recently passed in the US Senate should continue to provide support for USDdenominated safe haven assets such as gold and US Treasuries.

Downside risks GDP growth in China has likely peaked this year at 11.9% and will slowdown in the fourth quarter. Monetary tightening measures will hurt demand prospects in China for oil.

Of the nearly 1 million b/d of additional non-OPEC oil supply expected in 2010 and 2011, Brazil and Russia account for almost 70%. Brazil has five new projects starting within the next two years, representing 355 thousand b/d of additional capacity. Most notable are Baleia Franca and Peregrino, as well as the much-anticipated start up of the Tupi pilot project by the end of this year. Russia has fewer and smaller projects scheduled to start in 2010 and 2011, most notablythe Yuri Korchagin which reached first oil merely weeks ago, but continues to benefit from continued ramp up of very large projects.

Production from the Vankor project, which started a year ago, has already increased to 265 thousand b/d as of mid-May and should reach 300 thousand b/d by the end of the year. Like Russia, Azerbaijan and Kazakhstan are also seeing significant growth from existing projects. ACG is expected to ramp up through 2013, reaching over 850 thousand b/d this year, up 5% versus last year, while Tengiz continues to come in stronger than expected, currently reaching production rates of about 540 thousand b/d after ramping up to 250 thousand b/d last year.

Decline continues to weigh on non-OPEC oil supply growth Despite growth in a handful of non-OECD regions, declines continue to depress volumes out of Norway and the UK. Combined, production is expected to fall by 55 thousand b/d in 2010 and 2011 despite the start-up of new projects. Malaysia has also seen dramatic annual declines with volumes falling 4.5% last year compared to 0.6% the prior year, and the trend to continue, estimating declines of 3-5% in coming years. On the other hand, Mexican oil supply seems to be declining at a slower rate. Since the second half of 2009, decline rates have trended lower, averaging 3-5% in the last couple of months versus 8-12% over the last two of years.

The global economy could start to decelerate Clearly, it is still too early to determine the exact impact that the European financial crisis will have on the real economy. Judging by the latest available data, the global industrial production cycle is fully in swing. In the Eurozone, the manufacturing PMI decelerated slightly in April, but still implied strong growth ahead. However, we find it increasingly likely that global economic activity will start to decelerate going forward. Europe suffers from a big North- South competitiveness divide, an indebted consumer and overstretched government finances all of which could put GDP growth on a lower trend path over the coming quarters. Moreover, it is no secret that European economies are closely interdependent when it comes to trade, so a crisis in Southern Europe can have a big impact on Northern European economies through the export channel.

In addition to the obvious trade linkages, European countries hold each other's debt, highlighting why contagion across the Eurozone occurred at such a rapid pace during the past few weeks

NGL supply is also a big surprise factor NGLs, liquids derived from the processing of natural gas, has been a surprising source of global liquids supply growth in recent years. The proliferation of natural gas projects worldwide, particularly increasingly large LNG projects, is a major factor of growth, contributing more liquids than even some new conventional crude oil projects . Based on our estimates, OPEC will supply about 800 thousand b/d of NGLs by the end of the year, up from only 300 thousand b/d in the last quarter of 2009 (Chart 18). After growing 6% last year, the expected growth in 2010 might reach 15% with another 10% expected in 2011. Even after accounting for recently announced delays with the start up of Qatargas III Trains 6 and 7, now scheduled to start March of 2011, Qatar remains a major contributor to NGL growth along with Iran, Saudi Arabia, UAE, and Nigeria.

OPEC crude supply to increase by about 550k b/d OPEC output growth is expected to come back to positive territory with an increase of 554 and 477 thousand b/d in 2010 and 2011, respectively, following last year's record fall in production. With sluggish demand and output recovery, spare capacity stands at about 6.4 million b/d with the addition of major new fields in Saudi Arabia and Angola. Saudi Arabia, in particular, has been especially slow in ramping up production despite net productive capacity increases of more than 1 million b/d since the end of 2008.